Pricing models, the freemium myth and why you may not be charging enough for your product

I’ve been pulled into a number of product and pricing meetings recently (for reasons unknown I’ve become the Foundry pricing and productization guy). I thought it would be helpful to put some of my thoughts into a blog post and hopefully spur some conversation in the comments and over email. With any broad topic, there are always exceptions to the general rules. There are also few absolutes and much of this advice varies depending on your specific product and market. And keep in mind here that I’m dealing generally with web services of some kind in the advice below (not consumer apps and not enterprise software). With those caveats, here are some ideas on pricing models:

– Beware of too many pricing tiers. Relative simplicity is helpful in many things related to building companies and pricing models are no exception. As it relates to pricing tiers, I favor fewer pricing levels. More tiers = more complication = more confusion. It also makes you more likely to violate some of the other ideas below. I generally like 3 or 4 product tiers plus one “call us for enterprise pricing” tier.

– Have a clear delineation between product tiers. Many companies initially offer a base level that includes all of the features of their product and then offer a little more of each feature at various incremental pricing levels. For some relatively straightforward services this can make sense (think Basecamp where your sales pitch is about offering more of a relatively defined thing, that everyone pretty much understands and values, and generally will want more of as they use the product more). For most products, however, this is a bad idea. For starters, most companies vastly overestimate their prospective customers’ ability to understand the features of their product (thinking the value of each feature is self evident). It also complicates the buying process as prospective customers try to figure out how much of each of those great features you’ve developed they want, and doesn’t create clear delineations between pricing tiers. While there are some features in almost any product that need to be priced this way, I generally favor opening up some number of completely new features with each pricing increment (say an analytics layer or workflow module, etc.). This has the side benefit of giving you lots of nice ways in your product itself to promote higher tiered features (think grayed out features – “click here to upgrade!”). It also makes the upper tier value propositions relatively straightforward – want X feature? You’ll need to purchase the Silver package for that.

– How about overlay features that you charge by the drink for? Many companies have parts of their product which some advanced users may want to access at every product level (API level access being a pretty obvious example). In these cases (and to be clear, these should be product features that a subset of your customer base is looking for – if not, they should likely fall into your regular pricing tiers) I think it’s fine to have an overlay where you charge incrementally to the base price of each tier ($X for every 1000 API calls or something similar).

– Be careful what you put a tariff on. You should understand very clearly what drives your own costs as you start to matrix out your pricing so you know what user behaviors cost you money. You should also understand (by talking to early users) what drives customer adoption, usage and lock-in of your product. And with all that in mind, be careful what you chose to put a tax on. There’s no hard and fast rule here and this is a nuanced conversation that’s hard to generalize and put into writing. But remember that your pricing will effect your customer’s behavior around your product. And I’ve found that many companies make the mistake of charging for features that are the key lock-in points for customers in their early use of a product and in so doing actually limit their likelihood of getting enough value out of the product that results in their becoming a long term user. To be clear, you should try to align (but not necessarily match exactly) customer value to customer cost. But not at the expense of lock-in. To keep on the Basecamp example, note that they allow for unlimited users at even the base pricing level. They (correctly) realized that while they could have easily charged for this they’re better off getting as many people in an organization using the product as possible.

– The freemium myth. I’ve been a great beneficiary of freemium models (as both a consumer and an investor) but I think for many companies the freemium model doesn’t make sense. If your product offers value out of the gate, if your service is such that it doesn’t necessarily benefit by having a large volume of users (and back-end data aggregation is probably not that benefit, which I point out since I often hear it used to justify fremium models for companies that in my mind shouldn’t have them), if you are selling largely to enterprises (companies) – you may not be the right candidate for a freemium model. I know it’s in vogue and I know that your product is so cool if only you could get a million people using it you’d blow past the typical freemium upgrade rates of 1-3%. But in all likelihood if you’re offering a product of value that’s well thought through, well designed and well architected, you’ll make more money by simply charging for your service out of the gate. (Note that I’m really not talking about consumer oriented applications here, where freemium models tend to make more sense)

– Don’t be afraid to charge for your product. The other benefit of not going down the freemium path is that avoids another common mistake companies often make which is not charging enough for their product. When you’re jumping from “free” to “something” that something often needs to be relatively modest – after all you don’t want to scare customers off and you do need enough of them to pay something in order to stay in business. But the reality is that if you have a good product, many users who will pay “something” will pay more than you think for your product. Put another way, those that get value out of what you do get enough value to be willing to pay a meaningful amount of money for it. You may lose a few people at the low end, but many products have a lower price elasticity than their creators realize. I’ve watched many companies spend untold cycles trying to raise the price of their product after initially setting prices so low that they essentially commoditized what they do. It’s also worth noting that if you get it wrong it’s a lot easier to lower prices than to raise them. And to be perfectly clear, I’m generally not a fan of the $19.99 entry price point for a product/service sold to business users. You can charge more. And you should.

– Beware the long “trial” period. I’ve written about this before. I think most companies offer too long a trial period for their product. Just like most customers who will pay for a product will pay more for that product, most trial users who will eventually become customers at 30 days will do so at 14 days. The idea here is to give people enough time to see how awesome you are but not too much time to change their minds or to forget about you. There was a great debate about this question when I wrote about it last time and I still haven’t found any academic research to back up my hypothesis, but that’s my opinion.

Hopefully some of these ideas will be helpful to you. Maybe a few will be provocative (as always, let me know!). I do recommend that companies working on their product pricing matrix spend plenty of time with customers to understand how they are using their product. It’s also helpful to bounce pricing ideas off of not just your early customers but also some trusted advisors who are not as close to what you’re doing. Getting a fresh set of eyes on your feature set is a good way to avoid drinking too much of your own cool-aid when it comes to your view of the ease with which potential customers will understand your value and pricing matrix.

A question about your tiers suggestion: Are you basing your tiers on incremental functionality or volume (qty)? If the former, it makes sense to have the lite, standard, deluxe tiers. If the latter, I'm against quantity-based tiers altogether. If your long tail of customers is going to be the SMB/SME space, why give the best pricing to the rare Large enterprise customer? Or more correctly, why penalize your bread and butter customer base just because they are smaller than the big guys?

sethlevine

I generally favor incremental functionality. While often there are some features that can and should be incremented up, if that's all you are doing it's probably the wrong model. Your final comment maps to my overall view the companies often don't charge enough – this is true at the low and the high end (but starts by having an entry price that is too low and therefore too hard to justify incrementing up enough).

Rags Srinivasan

The dimension the versions should differ across depend on
– how the utility of the factors differ across segments (hence their WTP)
– how profitable it is for us to produce that versioning
While we can settle for rules of thumb, there are well established marketing research methods available to us (.e.g, conjoint analysis) to answer the first question. These may be new to tech startups but are used most extensively in every other industry (especially CPGs).

-rags

http://twitter.com/lmckeogh @lmckeogh

I would tier based on functionality only. Quantity discounts, IMO, deserve a value split and are in a different category. For these, there would only be one tier which is full functionality. Economies of scale come into play when I can sell 100 to 1 customer vs. one to a 100 people. From a selling point of view sales and distribution gets cheaper. Bonus to the seller.

From a customer point of view though, there is a learning curve. Who is going to pay for this? The company that is purchasing the product? One could almost estimate the product to the company now costs double. Seller gets all the benefit while customer pays and keeps paying? Sure there may be some overarching benefit down the road but they probably have managed to limp along up to this point. The pain is probably not really killing them. Lower this barrier to entry enough to get them to make the purchase.

Splitting the value so that the customer gets a break and the seller gets a break makes it a shared investment. Both sides want it to work because it is not so one-sided.

In the long-tail analogy, the single customer is almost the exact opposite of the enterprise sale. There is no economy of scale benefit to the seller. There are higher channel and support costs. It would cause the seller to question selling to the long tail except if there is a higher charge to cover these costs.

http://twitter.com/lmckeogh @lmckeogh

Great points Seth that I can say are as applicable outside of the web services space as they are within it. Specifically:

With respect to the pricing tiers – I am a big proponent of the KISS principle, especially in web services. Why? Keeping it simple keeps the cerebral cortex or the logic portion of the brain from engaging. The customer is more likely to be operating from the reptilian brain or emotional state. Increasing the complexity causes a buyer to think and it no longer is an impulse purchase. I am not trying to be deceptive, but also not trying to make revenue generation harder than it has to be. If a customer is thinking then they might go one step further and do a product/service comparison. Who knows where they end up in this process.

Regarding charging for your product – you can always go lower. There is gravity to assist with that. Unfortunately, it works both ways. It is infinitely harder to raise prices once the value has been anchored. The exception would be the fine merchandise market (e.g., wine, jewelry, art, etc.) For technology based products lower price generally translates to higher volume. Why leave money on the table if you don't have to. The technology curve will cause the price to come down over time naturally. This will also benefit your follow on products because these will surely be as or more expensive to produce.

sethlevine

Great points. Completely agree.

EMK

This is really super-helpful!

I've noticed that when I use a product with a long trial period I almost always end up canceling or not signing up — and walking away with a bad taste in my mouth if there's a lot of nagging in the final days, too.

sethlevine

I really wish someone would do a study about this and actually test the theory. I agree with you – I think 30 day trial periods give users too much time to get past the honeymoon period and into the "I really wish it did this" period.

http://twitter.com/chrisyeh Chris Yeh

Our empirical experience at PBworks backs you up, at least for an enterprise SaaS product.

We started out with a quantity-limited trial–3 users or less. This encouraged exactly the wrong behavior. People would *avoid* adding users, which defeats the purpose of collaboration software.

We then switched to a 30-day trial. We were conservative here, since a previous experiment with 7-day trials several years ago went disastrously.

After a while, we conducted some analysis that showed that we could tell after 7 days whether or not someone was going to buy, and that waiting simply deferred revenues.

We switched from 30 days to 14 days with nary a blip in our revenues, which have continued to increase steadily.

sethlevine

thanks for the data chris. this matches my experience with a few other companies as well (they could tell with almost complete accuracy after a week or 10 days who was going to actually sign up). helpful to have you chime in!

http://ahrono.com Miha Ahronovitz

The pricing system described in the article is based on 'how-to" hints. IMO it misses a central tenet. There is NO one price for all. It depends on customers' perception of value. A financial customer will pay more for a software product that each day of not having it, means $2M in lost profits (e.g. derivative trading). The same software product in in an University does not have this direct profit dependency and must be sold at a much lower price.

sethlevine

I think I state pretty clearly that each company needs to consider its own product, market and value. That said, I’ve been involved in pricing conversations for dozens of companies and these themes are pretty broadly applicable. Also keep in mind that these ideas likely hold whether your product is tiered at $5k/mo or $50/mo. In my opinion…

http://ahrono.com Miha Ahronovitz

The way to build prices is based on the following formula:
EVC = Reference Value + Differentiation Value
EVC is the Economic Value to the Customer. This is maximum amount a customer is willing to pay , assuming s/he is fully informed about the benefits of the product.
Note that various customers in various market segments or Geographical locations or industries have DIFFERENT perceptions of EVC. Therefore we can not have one price for everyone.

http://ahrono.com Miha Ahronovitz

We will not leave money on the table if we know the customers' business, and work with the customer to the EVC specific for his business

http://ahrono.com Miha Ahronovitz

Sure. However the accent should be ALWAYS to consider it's own product from the customer point of view. The ideas expressed come from the Product Management Executive program at Haas School UC Berkeley, of which I am an alumni. In fact we are discourage to use market share as reported by analysts (IDC, Gartner and so on). Too imprecise, vague We are encouraged to list actual customer names, specifically. Say we visit 20 customers and we know exactly their perception of value, so we can apply the formula. If the ECS (see next note) is too low, we don't have a product, unless we hypnotize the customer who is not informed. It may work once or twice, then we are finished… We want the contrary to happen.

sethlevine

we’re in completely agreement there. too many companies don’t spend enough time really understanding the value drivers from their customer’s perspective and then jump to conclusions around tiering and pricing that turn out to be completely incongruent to how the market views their product.

http://ctrlrm.com Julian A Waters

Great article, thank you, I will be implementing this advice.

PhilSugar

Totally agree that you can always lower price but its really hard to raise it…..we were thinking about this at the same time. I wrote about it at justanentrepreneur. Good post.

rtoennis

Thanks for a GREAT post, Seth. Found it via Brad's blog pointing here.

We have through trial and error arrived at some of the same insights you share but not some of the others (Short trial periods). Seeing your post really fuels my fire to push through the pricing fears and do what you are suggesting.

I think all the free/freemium services of the last 10 years have created an amazing pricing opportunity for entrepreneurs where an online service can separate itself from the competition and get traction by actually being significantly MORE expensive, even WAY more expensive. But it requires something from the entrepreneur they may not be comfortable with. (More on that below).

Chris Anderson in his book "FREE: The Future of a Radical Price" I think is projecting "FREE" to continue when in fact it is a local phenomenon and that right now we are hitting an inflection point back toward "You Get What You Pay For".

His core mistake in his "FREE" book is in not recognizing some fundamental universal laws. The "No Free lunch" law (2nd law of Thermo) and the "Time is Money" law (Hawking's unidirectional 'Arrow' of time). The "Free" effect, economically speaking, is a very local phenomenon that cannot extrapolate or scale broadly as a true basis for economic stability. In a "mathematical model of economics" sense Free is a "local slope" in the curve that taken farther hit's an inflection point in the "economic model of the internet" exploration curve we are traveling on.

The key to true success with a startup in this new local area of the "evolution of the internet economy" is understanding what your paying customers care about and what they need help with and then doing something that directly meets that need. Hmmm. Sounds like a place we've been before. 😉 I think it means the internet economy is finally on a trajectory to maturity.

The core issue for ALL small/medium businesses today is they are overwhelmed and "under-timed" (Not enough time in the day) trying to survive a strategic reduction in consumption by consumer's coming down off "materialism-bender) ("Walmartism") of the 90s/00s.

NONE of the businesses you want to sell a SaaS service to today have the problem of "not having enough logins to cool new, Freemium SaaS services with cutesy-pie names".

We have a business solution we were initially thinking of offering at $49/month as a self-service, SaaS solution for businesses and hoping to move up in price over time with features. That was not working and we found ourselves lost in the clutter of options businesses had to choose from. So we decided to change the basis of competition from "features to service" from "ease of use of a SAAS Technology tool" to "we run the tools for you and deliver you the results and the bill so it's really easy for you to pay us".

So we made this change and we moved the initial baseline price to 10X of $49 that, yes that's right, 10X ($499/month) Since we have actually had way more success in getting serious customer interest and we may move the price up even further. The key was in recognizing SMB businesses desperately want the simplicity of a "soup to nuts" bundle of product services that result in a full outsourcing of various core business functions.

Most of them actually now HATE technology-centric, SAAS products that have more cool then results.

When you offer a "soup to nuts", "we'll do it all for you", product/service solution bundle, it immediately translates in a small business owners mind as "a time saving way to ease my mind and help me put the fire in my hair out."

The challenge to doing a startup like this is the management challenge of scaling a 'full service" SaaS solutions model. Fortunately my team and I have a lot of big company experience building and leveraging VAR(Value added Reseller) programs that deliver both product and personalized "soup to nuts" services around the product.

The hype-filled days of "Build a cool online service that goes viral on it's own" are I think are pretty much over now. Now the real, hard, grungy work of actually understanding a business customer and serving their core needs continuously over time is back. Thank goodness.

R

http://www.derekscruggs.com Derek Scruggs

I saw Anderson's speak at SXSW and based on that I got the sense that he really has not thought much about B2B. In fact, one of my partners asked a question about perception of value. (We've found that some customers assume that because we offer a free version it must not be very good.)

His answer was less than satisfying. He kept referring to the idea of an online version of Photoshop, as if designers are the canonical B2B buyer.

sethlevine

pretty interesting, Derek. my sense is that for many (most) B2B companies, freemium is not the way to go.

http://www.ppcsoft.com/blog/ Atle Iversen

Unfortunately, the combination of
– freemium model
– free, open-source software
– VC-backed, "we'll figure out how to make money later when we're out of VC money"

has "taught" people that software and web services should be free, so for those of us trying to run "traditional" businesses struggle to convince people that "yes, we actually need to make money to pay for salaries and further development for the software you love".

sethlevine

i’m hopeful that this trend will be reversed. i actually believe that people (particularly businesses) are willing to pay for value. but you have to ask them to (and not give them a free version that allows them to avoid paying…).

http://www.ppcsoft.com/blog/ Atle Iversen

I hope so too

And I think you're right regarding businesses – this is why we decided to discontinue our free 2009 version when we upgraded to 2010; if you find it valuable, you shouldn't have a problem paying for it as well.

http://graduatetutor.com/ senith @ mba tutor

Great post. Matching pricing to cost is key especially if it is a service business. Even for a web business it there is some human intervention, the time cost adds up.

http://www.iagate.com Hatim Eltahir

I have unique services to be provided through a set-top-box which we made execlusivly for these services, we are thiking of 3 pricing models, any of them is fine for us , but we are not sure for customers prespective how that be, please advice?

A) Give the customer a FREE device (S.T.B.) and charge him $15/Month (To be paid anually in advance)

Please note that we are selling our products and services online for worldwide customers.

sethlevine

tivo has been through this with a similar model and settled on an up front price and monthly fee, typically with a few months free. i don’t like the model where you send a physical product (i.e., with real marginal cost) for free and then make it up on a monthly fee (you shouldn’t have to subsidize your customers like this). so my preference in your case would be to charge something up front that covers the cost of the equipment, install, support, etc. and then a monthly fee on top of that. i like the idea of giving a few months free, but 6 is too many in my opinion (people get too used to not paying). one or two months (maybe as a “promotion”) should do the trick. let me know what you decide to do!

http://www.iagate.com Hatim

Thanks Seth,

I like Tivo pricing model, I agree with you not to give the box for free, I think we can do the following:

Still we have 7 months to launch our service, we have time to develop our pricing model , I will keep in touch with you to discuss any updates.

http://twitter.com/katzpdx Jeff Katz

Seth: Great post.

At my start-up (http://www.twitalyzer.com) we just went through this exercise n June of going from what was a 100% completely free solution to a freemium model iand we could not be happier. It was a challenge for us to come up with the right mix of features for each tiered option (3 + free) so that our existing and new users would have a clear picture of the value of each subscription level. In many cases, the free option is more than enough for many the businesses and organizations using our solution which is fine with us.

We found that getting feedback from our users and potential users about pricing was an invaluable part of the process as it allowed us to launch the freemium model with a high level of confidence that we would not alienate existing users and allow us to actually bring revenue into our company.

— Jeff

sethlevine

jeff – i’d be interested to know your conversion stats to paid when you’ve got some data collected (what percentage of people end up paying for the service and at what price points). thanks!

http://chatfe.com/ Paul Orlando

Nice post and follow-up responses.

Freemium certainly doesn’t work for everybody. And it’s dangerous in that it can be another case of a cool catchphrase clouding people’s vision.

Still we have 7 months to launch our service, we have time to develop our pricing model , I will keep in touch with you do discuss any updates.

bullspit

Check your retweet share button, it does not tiny the url for some reason. Thanks for the great post!

sethlevine

thanks. i’ll see what’s going on.

seth

http://shahneil.com Neil Shah

Seth, this is an excellent post and equally backed up by great discussion which is going over here. I have wondered how pricing models can be a game-changer/spoiler in certain situations. Being myself as an Wireless Industry Analyst, lets cite the latest example of AT&T adopting tiered-pricing data plans shifting away from the unlimited data plans. The two levels of tiered-data plans are now offered – 250MB download cap for $15/month and 2GB download cap fro $25/month moving away from $30 all-you-can-eat plan..How does this fair from carrier and consumers point of view?? Will it be successful ??

It certainly presents multiple benefits for the carrier –

1. Expanding the Total-Addressable-Market for the carrier in roping the normal voice users to include affordable data plans and at the same time lure with heavily subsidized and attractive smartphones such as Apple iPhone. The carrier has a clear benefit of increasing its data ARPU.

2. Secondly it also presents carrier a more clear visibility in identifying the data usage patterns for its customers so it can plan future services as the industry is seeing moving value in applications and services..and plan additionally for these services on top of the $15 plan which the carrier wud be reluctant to do if the customer was already giving a larger share from its pocket ($30)…So now u have more customers who will be paying for more services as they are locked-in to smartphone dependencies…

From consumer's point of view..it benefits in terms of avg consumer will now be able to afford a smartphone and browse and access web from its mobile handheld computer and other cool service s and apps…but the disadvantage might be as consumer begins to get more and more used to these services and starts using more services and bandwidththis tiered pricing can certainly send jitters of a "bill shock" to consumers and which might affect the overall user-experience and consumer might think of switching to a different service provider who might be ofering all-u-can-eat plans with an equally cool smartphone…So with 4G LTE kicking, I am very keen to see which model will be successful…tiered pricing or all-u-can-eat…As still there are carriers such as Clear-Sprint who doesn't plan to introduce tiered pricing for their 4G WiMAX service..So will the consumer shift to all-u-can-eat to future for more bandwidth (which definitely will be the case), in that case will AT&T be able to step and move back towards all-u-can-eat plan or will it transition into an entirely new pricing model such as Quality of Service based pricing but all-u-can-eat ?? I would like to know your views on this…Thanks again for sharing your insightful thoughts…

sethlevine

Neil – One of my favorite examples of innovative pricing comes from the telecom world (although not wireless): the MCI original friends and family pricing plan. It was brilliant marketing, relied entirely on billing technology (i.e., was extremely difficult for AT&T to respond to) and was one of the reasons MCI really took off in the early days (and eventually their flat rate pricing plan, interestingly enough).

With respect to AT&T’s decision to move to tiered data plans, I guess I have mixed feelings. I think they’re mainly doing it to try to literally put a price on data in a way that forces their heavy data users to understand the load they are putting on the system. I ran an ISP in the 90’s and we had a similar problem to the one AT&T is facing – a very small % of our customers used all the bandwidth. The numbers are clearly much larger for AT&T but I imagine the ratios are similar and I feel some amount of sympathy for their pain.

Overall, however I generally prefer all you can eat pricing (for the simplicity of it). Especially for those things that are hard for customers to understand ahead of time their usage patterns (like bandwidth usage).

Great comment. Thanks for taking the time to write in.

http://shahneil.com Neil Shah

Thanks for the excellent response and drawing out some good examples, yes the data off-loading remains one of the main reason to suppress the small % of demanding users (esp:the early adopters and tech geeks), but there are so many other factors influencing the "real value" derived from a particular pricing – i.e in form of the bundled handset and services, quality of network, network coverage and overall brand experience. So here I believe AT&T with its tiered pricing might actually have an advantage to try an offset the negatives associated with this pricing model. if they excel in the value delivered by the underlying factors..which in turn helps AT&T in removing the pricing as the "barrier to access" for an avg. consumer to avail this extra value…I hope if this works you might see all the carriers in USA following this model..In Western Europe Vodafone, O2 have already started following tiered pricing for the iPhone and iPad and not spoiling the consumers minds and habits with all-u-can-eat plans..and a breather for their networks too..

sethlevine

Your points here are all pretty valid. For some reason mobile has actually benefitted by more, rather than less complicated pricing models. I’m not sure why it is but in the mobile world consumers prefer to buy completely a la carte. What will be interesting is to see whether consumers understand the data tiers well enough to make informed choices or whether AT&T will have a nightmare of a time with angry users who go over their data plans and trip expensive pricing increases (unlike a “minute” which is pretty obvious to most people, use of a “gig” of data is a bit more ethereal).

http://www.dudumimran.com Dudu Mimran

Hi Seth,

I found your post highly interesting to a topic I am contemplating on a lot these days. I have to admit that although there are quite a few "good" rules of thumb like you pointed above still I find the whole pricing topic very hard to formulate in some structured way and each startup has its own story which makes pricing considerations totally different.

I am currently a partner in a startup that develops a web service planned to serve mobile developers as customers. The service has high value for the developers so setting few tiers is the right direction to go. Our problem is another dimension of the web service; the "consumer" aspect of the web service. The more mobile developers using the service the higher the value the web service API provides. I know it sounds abstract a bit; but try to think of it like a marketplace in some way where a participant has value from the service itself and from the size of the community which makes the marketplace. Our approach is to provide a free tier with the basic capabilities and then to set tiers with pricing tag on them. Although this is the best idea we have come with still I am not fully "ok" with it. I feel the "free" creates some kind of a wrong impression for paying customers and might create a confusion.

Any thoughts on a similar structure?

Thanks,
Dudu

sethlevine

Dudu – It’s a bit hard to answer in the abstract (feel free to write me privately if you’d like to dive into it outside of a public forum – seth[at]sethlevine.com). If there’s truly value in the community then having a free layer is often beneficial – just validate that this is really the case and have compelling reasons for people to move from free to paid.